The consensus in market scholarship seems to be not only that “still waters run deep” but that deep waters run still. The greater the depth of volume in a commodity, the lesser the volatility of that commodity’s price. (This of course requires the usual “other things being equal” caveat.)
This consensus has held, despite the intense debate early this decade about the so-called Masters hypothesis, a debate in academia, amongst the public, and amongst activist groups, concerning the allegedly pernicious influence of commodity index traders (CITs). There was a view pressed forward around the time of the global financial crisis that that the sheer volume of CIT activity, especially in the period 2006-08, had contributed to an increase in food prices, which in turn had hurt the cause of alleviating global hunger. The CITs made the ‘waters’ of ag prices more agitated by deepening the pools.
A Search for Supporting Evidence
Matthias Georg Will and three associates put together a review of the empirical research on the subject of a CIT/ag-prices connection, surveying 35 studies published between 2010 and 2012. Ten of these studies appeared in peer-reviewed articles, the other 25 in what Will et al. call “grey literature,” that is, they were scholarly and econometric although not pre-publication peer reviewed.
Will et al. conclude that “there is little supporting evidence that the recent increase in financial speculation has caused an increase either in the price level or in the volatility of agricultural commodities. “ Debate seems to have rediscovered the pre-Masters consensus about still waters.
Michael W. Masters is the eponymous founder of the Masters hypothesis. On March 25, 2010 he told the US CFTC that passive speculation as embodied by the CITs “is completely blind to the supply and demand realities in the market. As such, passive speculators not only undermine, but actually destroy the price discovery function of the market and make way for the formation of speculative bubbles.”
An early statement of the contrary view came from Scott Irwin and Dwight Sandler, in a working paper for the OECD. Irwin and Sandler, together and severally, have had much to say on the subject since. Indeed, six of the ten articles in the Will core group were written in collaboration with one or the other, Irwin or Sandler. Concerned that this may make the “overall number of authors” in their core group too small, Will et al look to the “grey literature” as a control.
Quotes from the Core Group
Here is a sample of the conclusions the surveyors of this controversy quote from the ten peer reviewed studies:
- “[F]ormal econometric tests fail to find a statistical link between commodity index positions and returns in grain futures markets. Both Granger causality tests and long-horizon regressions generally fail to reject the null hypothesis that commodity index positions have no impact on futures prices.”
- “Commodity index rolls have little future price impact, and outflows from commodity index investment do not cause future prices to change.”
- “[L]imiting the participation of index fund investors would diminish an important source of risk-bearing capacity at a time when such capacity is in high demand.”
Quotes from the Control Group
But, as noted, it is possible that the core group is too heavily influenced by a small number of prolific scholars. So here are some quotations from the control group.
- “[W]ith respect to the six heavily traded agricultural and energy commodities examined, we do not find robust evidence that this [a causal link with passive speculation] is the case. We thus conclude that the increasing financialization of raw material markets over the last decade has not made them more volatile.”
- “With respect to twelve increasingly financialized grain, livestock, and soft commodities, we do not find robust evidence that CITs can be held responsible for making their futures prices more volatile. Indeed, we detect volatility persistence and a positive effect of unexpected overall trading volume, confirming prior results in the literature.”
- “Through correlations, Granger-causality tests, and contemporaneous tests with instrumental variables, we find that speculative groups like hedge funds and commodity swap dealer position changes do not lead price changes, but rather lead to reduced market volatility.”
There are dissenting views in this literature, but even they are as a rule quite tentative about their dissent. For example, Will et al cite a paper by Christopher Gilbert of Johns Hopkins and Simone Pfuderer of the University of Reading. Those authors claimed to have found a correlation between financial speculation and higher prices of soy oil, feeder cattle, live cattle, and lean hogs. But they find no such effect for corn, wheat, or soybean markets. Also, even where they do find a correlation, they acknowledge they have no clear empirical evidence about the direction of causality.
The conclusion of Will et al is unambiguous: “If one considers the empirical evidence in its entirety, the alarm raised by [activists] must, inevitably, be regarded as a false alarm.” Italics in original.